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Economics: Defining Average Variable Costs

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  • Type: Video Tutorial
  • Length: 5:40
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 60 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Production and Costs (24 lessons, $39.60)
Economics: Average Costs (3 lessons, $4.95)

This video lesson will define the idea of Average Variable Costs (AVC). You'll learn what these costs are and when they're used in economic analyses. Taught by Professor Tomlinson, this video lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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Thinkwell
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So we're back for another lecture in the continuing series on cost curves and productivity. We've been talking a lot about marginal cost, the cost of producing an extra unit of output. It's going to turn out that the concept of marginal cost is very important when it comes to a firm deciding how much output to produce. You don't want to produce another unit of output if the cost is greater than the money that you can earn by selling it. If cost exceeds price, you don't want to produce the unit of output. Marginal cost becomes a guide to a firm that's trying to decide how much output to produce.
We're now going to talk about the concept of average cost. Average cost isn't a guide to the firm in how much output to produce, but it does tell the firm that is choosing how much to produce whether they can make a profit or not. Marginal tells you how much to produce, average cost tells you whether you're going to be profitable doing it or not. Let me see if I can make this clear by first defining average and then talking a little bit about what it means for a firm that's trying to maximize profits.
Let's begin with a definition. The average variable cost is the cost of labor per unit of output produced. That is, it is your variable cost, your total wage bill, divided by the total number of television sets you produce. Let's look now at some numbers that will make this clearer. Suppose we have one worker producing two television sets, and we're paying that worker a total of $1,000 a week. That's his wage. Well, if you divide that $1,000 variable cost by two television sets, you get an average variable cost of $500. There's $500 worth of labor going in to each of the two televisions that you're producing. So the average variable cost or labor cost per unit is equal to $500. If you hire two workers, you can produce a total of 10 television sets. Those ten television sets are going to cost you $2,000 worth of labor expense because two workers times $1,000 each is $2,000. Divide $2,000 by ten televisions, and the average variable cost is now $200 worth of labor per television set produced. Keep going. Three workers make 30 television sets, $3,000 worth of labor expense for an average variable cost of $100. And that continues. Four producing 40 televisions, $4,000, again, $100 per television set. Five producing 45 television sets, $5,000 worth of labor expense divided by 45 televisions is about $111 of labor per television set, and so forth. You can go ahead and complete the chart.
I'll now move these numbers over there so that we can use them in a minute whenever we draw the curves. The point that I want to make is this. Average variable cost is the total amount of money you were spending on labor divided by the number of television sets you make. If, for example, you can only sell a television set for $150, then it doesn't make any sense to be producing 10 television sets with two workers, because you're spending $200 on the labor alone, not to mention the cost of your factory and tools and everything else. If this average variable cost is greater than the price of the television set, you know that you'll be making a loss producing the televisions. See, you can use this number to help you figure out whether you can make a profit or not in this business.
Down here, however, if you can sell your television sets for $150 apiece, then it might make sense to make 40 television sets a week with four workers. That's because the labor cost per television set is only $100. Now, that leaves some room for other costs of production associated with the fixed inputs, that is, paying the overhead on your factory, the tools, the utilities, all that other stuff. If that comes to less than $50 per set, then your cost of production will be less than the price, and in that case you can make a profit.
We'll see later how these things all fit together, but I want to get you ready thinking about average variable costs as a guide to whether your operation is going to be profitable or not. So the definition of average variable cost is the labor cost per unit produced, and notice that it varies as we change the amount of output that we're producing. Do you have any idea why? Think for a moment. Why would average variable cost change as you change the amount of output that you produce? Of course, the answer has something to do with productivity, right? The more productive your workers are, the fewer workers you'll need to produce television sets and therefore, the lower the cost on average. The more productive your workers are, the lower the cost. And as productivity changes, the cost of production will be changing.
Next, we're going to draw a picture to show what the average variable cost looks like in a graph, and then we'll talk about the inverse relationship between average variable cost and it's related productivity concept, the average product of labor.
Production and Costs
Average Costs
Defining Average Variable Costs Page [1 of 1]

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